Callaway Golf Finds Its Groove

New products, cost cuts, and resilient golf consumers are expected to drive higher profits for the company in 2008

by David Bogoslaw

When the going gets tough, the tough go golfing. At least that's what it looks like from Callaway Golf's (ELY) projected jump in sales at a time when people are cutting back on other discretionary expenses, and even consumer staples are at risk.

On Jan. 16, the manufacturer of golf equipment and accessories estimated a 10% gain in net sales to a record $1.25 billion for 2007. Projected earnings of 79 to 81 cents per share for the year include non-cash employee equity-based compensation charges related to financial accounting standards.

The shares jumped 11.8% to close at $15.59 on Jan. 17.

But that gain isn't as impressive as it first appears when you consider that the stock's value had dropped 20% over the past two weeks after a couple of golf retailers said that the momentum of sales in the category had slowed substantially, said James Hardiman, an analyst at FTN Midwest Research in Cleveland, Ohio. That led the market to assume that Callaway's sales would have taken a hit as well, he said. (FTN Midwest Securities makes a market in Callaway's securities.)

Callaway's latest earnings outlook was anywhere from meeting market expectations to beating expectations by two cents per share. "Given the terrible consumer discretionary environment we find ourselves in, just making their earnings number and beating it by a penny or two is big news," Hardiman said.

Besides introducing new products such as its square-head driver, the Carlsbad, Calif.-based company has been adept at cutting a lot of costs out of its operations. By shifting its manufacturing operations to Massachusetts from Carlsbad, as well as to locations overseas, and increasing automation at its plants, Callaway has been able to widen its margins, Hardiman said. The company has also benefited by shortening the time it takes to recognize trends in the sporting goods market -- such as which kinds of golf accessories are selling well vs. those that aren't -- and responding to those trends more quickly, he said.

With investors more focused on the company's outlook for 2008, the stock could get another boost if Callaway provides some detail on its expectations during its fourth-quarter earnings conference call on Jan. 31 or at a meeting with analysts scheduled for Feb. 7, he said.

The introduction of new products such as two new drivers to be launched at the upcoming PGA Show has retailers feeling more confident about the spring selling season, said John Shanley, an analyst at Susquehanna Financial.

Another reason that Callaway's profits are expected to improve is the expansion of its accessory product category, items like bags and shirts, he said. “Those margins tend to be better than they are with clubs or irons and that helps the bottom-line results.”

Shanley has a neutral rating on the stock and expects Callaway to earn 89 cents per share for 2007, slightly more than the average forecast among Wall Street analysts of 87 cents per share on $1.11 billion in revenue.

Driven by its improved product offerings, Callaway's gross margin is expected to be rise by nearly 5% in 2007 and could just be getting started, Morgan Joseph & Co. said in a Jan. 17 research note. Ongoing manufacturing initiatives will continue to help margins on earnings before interest and taxes widen towards 15% from 4.5% in 2006 and an estimated 9.1% in 2007, according to Morgan Joseph, which has a buy rating on the stock. (Morgan Joseph plans to seek or expects to receive compensation for investment banking services from Callaway within the next three months.)

Callaway's ace in the hole is the fact that it caters to the “higher-end consumer [who's] going to do better regardless of what the economic backdrop is,” said Hardiman, who has a neutral rating on the stock.

That said, wealthy people haven't been doing well recently and are also cutting back on their discretionary spending, he noted.

"Historically, golf retailers have done well. Even when economy hasn't been good, people have continued to golf,” he said. “The question is are people going to continue to spend on $300, $400, $500 drivers?"

To some degree, Callaway can offset that with market share gains if it's successful with its new products, but it's not immune to the economic tumult, he said.

Shanley at Susquehanna said he had no doubt that Callaway's customers would continue to be willing to shell out big bucks for a specialized golf club they really want. "Their products are aimed at the golf fanatic who plays at least 25 or more rounds per year and tend to be somewhat price-immune," he said.

Wachovia analyst Timothy Conder upgraded Callaway's stock on Jan. 17 to outperform from market perform with a $17 to $19 valuation range. Despite a slowing U.S. consumer environment and strong 2007 comparative-store sales, Condor predicted the company can expand its market share modestly in 2008 with its I-MIX interchangeable heads and shafts, wooden clubs, hybrid clubs and Callaway-branded golf balls. And with the valuation near the lower end of its historic range, the shares should be attractive to investors, he said.

He predicted the seasonally weak fourth-quarter results will be solid and said the initial 2008 profit forecast is supportive. But he trimmed his earnings estimate for the new year $1.25 from $1.30 per share, citing the slowing consumer environment.

Bogoslaw is a reporter for BusinessWeek's Investing channel .